Tuesday, January 17, 2017

Why Fed Watchers Think Yellen Is Plotting Three Hikes This Year

Process of elimination leaves less room among doves for chair; NY Fed’s Dudley may also favor three rate increases this year.

By Rich Miller and Christopher Condon

Bloomberg

January 17, 2017

Has Federal Reserve Chair Janet Yellen been outed as favoring three interest-rate increases this year, as opposed to a more dovish two?

That’s the buzz making the rounds among hard-core Fed watchers as they parse an outpouring of comments by policy makers over the past four weeks.

“Yellen likely put down three hikes” for 2017 when Fed policy makers submitted projections in December, according to Laurence Meyer, a former Federal Reserve governor who now heads a policy analysis firm in Washington that bears his name.

Meyer is playing a game of elimination popular among investors and economists that revolves around the so-called dot plot. That’s a graphic layout that the Fed publishes every three months to show where policy makers think interest rates should go if their forecasts for the economy prove accurate. The quarterly rate projections don’t identify the author of each forecast, which is represented by a dot on a chart.

The latest dot plot, released the same day the Fed raised its benchmark lending rate on Dec. 14, caught investors on the hop by showing the median projection was for three increases in 2017 rather than the more dovish two expected in September.

Yellen is widely perceived as a dove, or a policy maker who focuses more on lowering unemployment than containing inflation. She also downplayed the change in rate projections when she spoke to reporters after last month’s meeting, saying it was just a quarter-point increase. That may have caused many investors to assume she is among the two-hike dots.

If Yellen is indeed among those expecting three rate hikes, that would increase the likelihood that the central bank will follow through with that number, given her sway over other members of the Federal Open Market Committee, which sets interest rates. It could also provide another jolt to investors, who still expect only two moves this year after one in 2016, according to trading in interest-rate derivative contracts.

Meyer said he used a process of elimination to peg Yellen at three, backed by his view of the chair as adept at building consensus on the committee, and by her increasingly rosy view of the economy in the short term. “I put a lot of weight on the fact that she has a very positive view of the economy, particularly on inflation,” he said.

The Reasoning

While the Fed chair has repeatedly refused to say where she stands on the dot plot, other officials have not been so reticent about their positions. And their comments and actions have helped Fed watchers use a process of elimination to pinpoint which dot they believe is Yellen’s.

For the central banking nerds out there, here’s how the reasoning breaks down. In December, two of the 17 FOMC participants projected just one hike in 2017, four expected two hikes and six called for three. The others forecast an even faster pace of tightening.

On the first rung stood St. Louis Fed President James Bullard -- who said on Dec. 16 he expects the central bank to raise rates just once in the next three years -- and outspoken dove Governor Lael Brainard, several Fed watchers said.

The Twos

Atlanta Fed President Dennis Lockhart told reporters on Jan. 9 that he had forecast two hikes this year. His Chicago counterpart Charles Evans suggested he’s also looking at two, saying on Jan. 6 that a couple of moves were “not an unreasonable expectation.” Next, Governor Daniel Tarullo, who in the past has advocated a decidedly cautious approach to raising rates, also got ranked at two hikes by several economists.

With a single two-hiker remaining, there is one more firm clue: In December, in the run-up to the FOMC meeting, the board of directors at the Minneapolis Fed was alone among the regional banks when it voted against increasing the so-called discount rate, which establishes interest rates for direct loans from the Fed. They did so to support the labor market and allow inflation to rise, according to minutes published on Jan. 10.

A reserve bank’s position on the discount rate typically reflects its president’s view with respect to the benchmark federal funds rate, suggesting Minneapolis Fed President Neel Kashkari isn’t hawkish enough to forecast more than two hikes this year on the dot plot.

Yellen, Dudley

If that’s correct, Yellen and New York Fed President William Dudley are among the six policy makers forecasting three hikes in 2017.

While Dudley hasn’t given any public comments to indicate where he stands on the dot plot, Yellen has arguably affirmed the conclusion that she forecast three hikes. She said in a Jan. 12 speech that U.S. economy faced no serious short-term obstacles, signaling she would be comfortable with a faster pace of monetary tightening. “Inflation has moved up from a very low level, and it’s a little bit under our 2 percent objective, but it’s pretty close,” she said.

Other economists cautioned that it’s impossible to know for sure which official corresponds with each dot, adding that the importance of Yellen’s position is limited by the uncertainty overhanging the Fed’s economic forecasts. And uncertainty is especially high given the lack of clarity over the incoming Trump administration’s plans on everything from infrastructure spending to tax cuts. About half of the FOMC participants included assumptions of more expansionary fiscal policy in their forecasts, according to the minutes of the December meeting.

“It doesn’t really matter” whether Yellen is at two or three, said Michael Gapen, chief U.S. economist at Barclays Plc in New York and a former Fed economist. “The over-arching message is the Fed’s not the only game in town anymore, and they know it. They’re going to respond to fiscal policy.”

Gapen put Yellen at two hikes, but said a case could be made for her at three.

Luke Tilley, chief economist at money manager Wilmington Trust Corp. and a former staffer at the Philadelphia Fed, offered another warning even as he agreed that Yellen likely projected three hikes.

“These are not telegraphed intentions, but expectations,” he said. “They’re willing to move them up or move them down based on how they see the economy.”